Credit Risk Transfer

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Credit Risk Transfer

• Michael Gibson
• April 17, 2008

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• This paper represents the views of the author and
  should not be interpreted as reflecting the views
  of the Board of Governors of the Federal Reserve
  System or other members of its staff.

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Credit risk transfer is the most important
development in finance
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Credit risk transfer is the most important
development in finance
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Credit risk transfer is the most important
development in finance
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Outline The Boom and The Bust
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The Boom
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ABS CDOs and CLOs
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Derivatives spurred the growth of CRT
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Derivatives spurred the growth of CRT
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Issuance up, standards down
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Issuance up, standards down
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Issuance up, standards down
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the suction from Wall Street
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CRT has spread to new investors

• Fixed income investors
• Global
• Monoline FGs
• Hedge funds

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Indexes have helped make credit a traded asset
class
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CRT instruments are quite complex
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Octans I CDO Ltd. liabilities
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Octans I CDO Ltd. assets

• 191 securities
• 115 Midprime RMBS (60 percent)
• 67 Subprime RMBS (35 percent)
• 7 CDOs (4 percent)
• 1 Alt-A, 1 subprime second-lien
• 180 rated Baa

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CRT instruments are quite complex

• ABS CDOs were model risk squared

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Role of credit ratings

• Especially for AAA
• Investors rely on ratings for CRT products more
  than they use to rely on ratings for corporate
  bonds

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Ratings dont tell the whole story for structured
finance securities
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Ratings dont tell the whole story for structured
finance securities
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All this set the stage for the subprime shock

• Weak market discipline
• New investors
• some focused on trading, not credit
• Complex CRT structures
• Relying on ratings

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The Bust
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How did the subprime shock spread so wide?

• Subprime RMBS is 1 trillion outstanding
• Total US debt 30 trillion
• Global financial assets 160 trillion

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Was credit risk transferred to those more willing
and able to bear it?

• Junior risk tranches seem to have been
  diversified or hedged
• Not so for senior tranches

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Risk management weaknesses at large firms

• 2007Q4 writedowns
• Citi 18 billion
• Merrill 16 billion
• UBS 14 billion
• Source SNL Financial from company reports

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What were some of the risk management failures?

• Super-senior risk
• Off-balance sheet exposures
• Complexity and valuation problems
• Counterparty risk (monoline FGs)

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BIS Credit Risk Transfer Report